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Mikko Ketokivi and Joseph T. Mahoney

Which components should a manufacturing firm make in-house, which should it co-produce, and which should it outsource? Who should sit on the firm’s board of directors? What is the right ...
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Which components should a manufacturing firm make in-house, which should it co-produce, and which should it outsource? Who should sit on the firm’s board of directors? What is the right balance between debt and equity financing?

These questions may appear different on the surface, but they are all variations on the same theme: how should a complex contractual relationship be governed to avoid waste and to create transaction value? Transaction Cost Economics (TCE) is one of the most established theories to address this fundamental question.

Ronald H. Coase, in 1937, was the first to highlight the importance of understanding the costs of transacting, but TCE as a formal theory started in earnest in the late 1960s and early 1970s as an attempt to understand and to make empirical predictions about vertical integration (“the make-or-buy decision”). In its history spanning now over five decades, TCE has expanded to become one of the most influential management theories, addressing not only the scale and scope of the firm but also many aspects of its internal workings, most notably corporate governance and organization design. TCE is therefore not only a theory of the firm, but also a theory of management and of governance.

At its foundation, TCE is a theory of organizational efficiency: how should a complex transaction be structured and governed so as to minimize waste? The efficiency objective calls for identifying the comparatively better organizational arrangement, the alternative that best matches the key features of the transaction. For example, a complex, risky, and recurring transaction may be very expensive to manage through a buyer-supplier contract; internalizing the transaction through vertical integration offers an economically more efficient approach than market exchange.

TCE seeks to describe and to understand two kinds of heterogeneity. The first kind is the diversity of transactions: what are the relevant dimensions with respect to which transactions differ from one another? The second kind is the diversity of organizations: what are the relevant alternatives in which organizational responses to transaction governance differ from one another? The ultimate objective in TCE is to understand discriminating alignment: which organizational response offers the feasible least-cost solution to govern a given transaction? Understanding discriminating alignment is also the main source of prescription derived from TCE.

The key points to be made when examining the logic and applicability of TCE are:

(1) The first phenomenon TCE sought to address was vertical integration, sometimes dubbed “the canonical TCE case.” But TCE has broader applicability to the examination of complex transactions and contracts more generally.

(2) TCE could be described as a constructive stakeholder theory where the primary objective is to ensure efficient transactions and avoidance of waste. TCE shares many features with contemporary stakeholder management principles.

(3) TCE offers a useful contrast and counterpoint to other organization theories, such as competence- and power-based theories of the firm. These other theories, of course, symmetrically inform TCE.